China has become an economic superpower and is now the world’s second-largest economy. It has its sights on the United States, which it could eclipse as the world’s largest economy between 2020 and 2030. Consider that the five most popular emerging markets funds have an average allocation of just 10.4% to the China market. An advisor who allocates 15% of his clients’ accounts to emerging markets leaves them with less than 1% invested in China. The need for a strategic approach to investing in this region is acute.

Over the past three decades, China’s economy has experienced robust growth as it shifts from a third-world country to a modern consumer economy and influential source of economic power. The view that China can be categorized within “emerging markets” no longer holds true, and a more accurate investment allocation to the Asian nation should be similar to those of other developed countries. In essence, China is no longer emerging, but rather, has emerged.

Incrementally, when investing in a broader emerging markets allocation, proper diversification must be ensured. The same principle holds true when investing in the Greater China region. The Greater China region is more complex in terms of equity share class structure.

By understanding the market dynamics of the region, it becomes clear that investing in Greater China requires approaching each market as its own asset class.

Under-Allocation of Assets

China’s population growth, consumption of commodity resources, urbanization and growth of equity capital markets are prominent trends. These factors will have significant implications on the future global benchmark re-weightings. In 2010, China was 9% of global GDP and represented 11% of global capitalization. These figures are estimated to rise to 17% and 20%, respectively, by 2020.

The impact of the changing global benchmarks presents an opportunity for advisors. Those who anticipate the macro impact of increased demand for securities—skating to where the puck will be instead of where it is—will be well-positioned to maximize results for their clients. Just as China has clearly graduated from emerging to emerged, a diversified portfolio should adjust its allocations accordingly to capitalize on the country’s continued momentum.

China’s Growth is Self-Sustaining

One of the most significant by-products of China’s growth is the dramatic shifting of its population above the poverty line. According to the IMF, more than 220 million Chinese have moved out of poverty since 1978 and the middle class is expected to grow to nearly 500 million people by 2025. The sheer numbers of China’s middle class are shifting the drivers of the country’s growth from exports to consumption. China is the world’s largest automotive market and energy consumer. In 2005, China’s middle class consumption ranked seventh globally at approximately 4%, but within the next decade that figure is expected to grow to approximately 13%. The growing appetite among these consumers for luxury goods and commodities is expected to exceed that of their U.S. counterparts within the next 10 years.

The result of this wealth shift is evident in the balance sheets of Chinese companies. Productivity is growing at 8.7%, which parallels the domestic demand as Chinese salaries and wages grow, and dividends within Chinese companies are increasing. Over the past two decades, reinvested dividends account for up to two-thirds of total returns from China. As the number of domestic Chinese consumers increase, export-oriented stocks as a percentage of total market capitalization are declining.

Active Management Within the Region

The investor experience in the United States has proven the benefits of indexing. However, to fully participate in the Greater China opportunity, one needs to consider which companies and stock markets to allocate investments. Companies may be listed in Taiwan, Hong Kong, Shenzhen and Shanghai or a combination of markets.

It’s crucial for investors to have exposure to these markets to gain the benefits of full diversification, as well as an experienced manager to make these decisions. Because the capital markets have yet to match the level of transparency, regulation and corporate governance in the United States, we don’t believe a passive management approach, whether through an ETF or mutual fund, provides an investor with appropriate opportunities. We feel that active management has distinct advantages in Greater China markets.